In an effort to encourage investment in the United States in new technologies and potential new product lines/revenue sources; and to ensure the United States stays competitive technologically with other countries, both the federal government and some state governments subsidize certain types of research and development costs (“qualified R&D expenditures”) incurred by United States businesses (businesses are companies or individuals). Businesses can obtain the government subsidies by claiming research and development tax credits (“R&D tax credits”), which reduces their tax liability on their tax returns. The federal R&D tax credit is set forth in Internal Revenue Code Section 41. R&D tax credits can be quite lucrative. The federal R&D tax credit alone is generally equal to 10% of “qualified R&D expenditures.” However, in order to obtain R&D tax credits, businesses must spend an inordinate amount of time and resources complying with the United States and various other state tax laws to determine: 1) what types of R&D projects and activities qualify for the R&D tax credit; and 2) how to accurately quantify the R&D tax credit. In order to achieve the two aforementioned tasks, businesses must collect, analyze, and retain a significant amount of supporting data and documentation. Besides having to collect, analyze and retain data in order to determine the exact amount of the R&D tax credit, the business must retain the collected/processed data/documentation as supporting evidentiary documentation for government tax audit purposes. Furthermore, the data must often be retained for several years, as government audits often take place several years after the year in which the R&D tax credit is claimed.
For instance, in order to determine what types of projects and activities qualify for the R&D tax credit, businesses must gather supporting documentation evidencing that the projects and activities meet the R&D qualification rules (set forth in Internal Revenue Code Section 41). After the qualifying projects and activities have been determined, the amount of time spent by each of the business' employees and contractors performing qualified R&D activities must be quantified. To quantify the qualifying R&D costs, each employee's and each contractor's percentage of time spent performing qualified R&D activities is applied to his/her compensation. Therefore, employee's compensation data, contractor's cost data, and supplies cost data must be obtained in order to quantify the R&D tax credit.
The Internal Revenue Service (IRS), as well as certain state tax agencies, requires detailed supporting evidence to support R&D tax credit claims. In addition, it is preferable that the evidence/documentation be contemporaneous primary source documentation, i.e., the documentation/data should be obtained directly from/submitted by the actual employees performing the R&D work contemporaneously. Therefore, to avoid challenge or denial of claimed R&D tax credits, businesses should create a process whereby each individual employee and contractor who performs qualified R&D activities complete/submit their own time reports indicating the percentage of time dedicated to R&D projects/activities.
However, requiring employees to complete/submit time reports can be challenging. Employees often do not want to take time out of their busy schedule to complete and submit the necessary contemporaneous information about how they spent their time during the year. The employee's reluctance to submit R&D information can result in a low response rate, and therefore weak and/or non-defendable tax credit claims. Furthermore, time and energy must be devoted to train the employees about R&D projects/activities, and to manage the R&D tax credit process in order to maximize the R&D tax credit and to ensure that the required R&D documentation is acceptable and properly retained.
In addition, as mentioned previously, evidence related to the qualification of R&D projects/activities, and time spent by the employee performing qualified R&D activities, should be in the form of primary source documents. That is, each employee engaged in R&D activities should submit contemporaneous documentation about the type of activity they performed, as well as the amount of time spent on qualified R&D projects and activities. A summary report completed by the employee's manager, or other higher level aggregated data source is unacceptable R&D tax credit documentation.
Failure to obtain, submit, accurately determine, and store the necessary supporting R&D tax credit documentation can result in lost R&D tax credits as well as penalties and interest assessments. Consequently, to claim the R&D tax credit with a high degree of confidence requires a significant amount of time and resources dedicated to properly documenting R&D project/activities, correctly calculating the R&D tax credit, and ensuring that the proper evidentiary documentation/data is maintained to support and defend the R&D tax credit claimed. These requirements can be a significant burden on businesses, but are particularly problematic for small businesses that often do not have the available resources to properly document the qualification of R&D projects/activities, correctly calculate the R&D tax credit, and ensure that the proper documentation is retained for audit purposes, merger and acquisition purposes, and/or for various other purposes desired and/or required.
As a result of the situation described above, many small businesses that would legitimately qualify for R&D tax credits fail to apply for the R&D tax credits because they do not completely understand the tax laws, and/or the process is viewed as far too burdensome, and/or the risks of incorrectly claiming an R&D tax credit are viewed as too high. For the same reasons, accounting professionals, such as Certified Public Accountants (CPAs), also often fail to take full advantage of legitimately available R&D tax credits, and/or to properly inform their small business clients of the available R&D tax credits and how to safely claim them.
In addition, even in cases where a small business legitimately qualifies for R&D tax credits, and appropriately claims the R&D tax credits on its tax returns, the small business often has no standardized, efficient, or even consistent method, process, or system in place for documenting the necessary supporting evidence of the claimed R&D tax credit, or calculating the R&D tax credit. As a result, significant inefficiencies are introduced which could result in: 1) the failure to maximize the amount of the potential R&D tax credit; 2) a risk of the denial of the R&D tax credit due to the lack of the necessary supporting documentation (incomplete and/or unacceptable documentation) to defend the claimed R&D tax credit; and/or 3) the incorrect calculation of the R&D tax credit claimed. If the government denies all or a portion of the R&D tax credit, penalties and interest could also be assessed.
The current situation serves to largely negate the positive effects and intended results of R&D tax credits, i.e., to encourage United States companies to engage in research and development to ensure that the United States remains competitive in the global marketplace; and to give United States businesses more capital to invest in R&D. Currently, many small businesses either forgo R&D tax credits they legitimately qualify for, thereby forgoing capital that could be invested in further research, or they waste resources on inefficient, and often ad-hoc, R&D tax credit documentation processes.
What is needed is an effective method and system whereby accounting professionals can offer their small business clients an efficient, consistent, and resource conserving process to identify, document, and calculate R&D tax credits; as well as an effective process to retain the supporting evidentiary data and documentation for use in the event of an audit, merger and acquisition, and/or for various other purposes desired and/or required.